Chapter 9 Business Law and Practice

9.2 What is income?

• No statutory of judicial definition of income

• Generally money is regarded as income if there is an element of recurrence e.g salary or interest in a bank account

9.3 Who pays income tax?

• Individuals, partners, personal representatives and trustees may have to pay income tax

• Charities are generally exempt from income tax

• Companies do not pay income tax, they pay corporation tax

Individuals -

• Employed individuals will have to pay income tax if their earnings exceed a designated threshold

  • This is usually assessed by their employer, who then pays this directly to HMRC

• Sole traders also have to pay income tax, based on an assessment of their trading profits:

  • Trading profits are generally calculated as such;

  • 1. Get the business’ chargeable receipts (aka the money it has received from trading)

  • 2. Subtract the chargeable receipts any deductible expenditure and capital allowances - the resulting amount is the trading profit (or loss)

• Individuals may also have to pay income tax on other types of income too such as investments, pensions, interest on bank accounts etc

Partners

• Partners are individually responsible for the tax due on their share of the partnership profits

• Method for calculating trading profit is the same as for sole traders (above)

• If one of the partners is a company, not an individual then they will have to pay corporation tax instead of income tax

Personal Representative

• Personal representatives pay the deceased’s outstanding income tax and income tax
  chargeable during the administration of the estate

Trustees

• Trustees pay income tax on income produced by the trust

9.4 The Tax Year

• The tax year runs from 6 April until 5 April the following year

• So an individual will pay tax on all income earned between these dates

• Tax year AKA the ‘Year of Assessment’

9.5 How to calculate income tax

• Rate of tax payable increases as income increases

• Tax is only payable on Taxable Income

  • Taxable income is calculated by deducting reliefs and allowances from the actual income

• Three categories of income are:

  • non-savings, non-dividend incomes (‘NSNDI’) - refers to all sources of income apart from income from savings and dividends

  • savings income - which is interest from various sources

  • dividend income

• Calculating income tax payable:

  • STEP 1: Calculate total income

  • STEP 2: Deduct any allowable reliefs (the resulting sum after this is net income)

  • STEP 3: Deduct any personal allowances (the resulting sum is taxable income)

  • STEP 4: Separate NSNDI, savings income and dividend income - and calculate the tax on each type of income using the applicable rates

  • STEP 5: Add together the amounts of tax from Step 4 to find the overall income tax liability

9.5 How to calculate income tax - Step 1: Total Income

• What income is charged to income tax under ITTOIA 2005 and ITEPA 2003? The most important sources of income are;

  • Trading Income

  • Property Income

  • Savings and Investment Income

  • Employment and Pensions Income

  • Certain Miscellaneous Income

• If the income is from one of the above, the individual will pay income tax

• If not, the individual cannot be taxed on this income (examples are damages for personal injury or death, certain state benefits, premium bond winnings, ISAs)

• Income is categorised because different sources are treated different when taxxing

• Deductions at source:

  • The taxpayer receives most types of income without any tax having been deducted
    beforehand

  • This is referred to as gross income

  
  

  • However, employment income (salaries) will already have tax deducted when the individual receives it — meaning they receive the net amount not the gross amount

    • Done through PAYE system

  • When calculating total income, this salary must be ‘grossed up’ to show the full amount of salary before tax

Savings and Dividend Income

• Interest and dividends are both paid gross - ie the tax is not taken off before it is paid out

• Both savings and dividend income benefit from
  annual tax-free allowances

• Both savings and dividend income form part of total income and must be added to other income at this stage

9.5 How to calculate income tax - Step 2: Allowable Reliefs

• Total income take away allowable reliefs = net income

• Certain amounts, allowable reliefs, are deducted from total income to give a figure for net income

• Most used is relief for interest payments on qualifying loans:

  • a loan to buy a share in a partnership, or to contribute capital or make a loan to a
    partnership;

  • a loan to invest in a close trading company; and

  • a loan to personal representatives to pay inheritance tax.

9.5 How to calculate income tax - Step 3: Personal Allowances

• Personal Allowance - the amount of income individuals are allowed to earn before they start paying income tax

• Personal allowance is deducted from net income to find the taxpayer’s taxable income

• Personal allowance for 2026/2027 is £12,570

• Personal allowance is applied in this order:

  • 1. against NSNDI

  • 2. (if there was a surplus) against savings income

  • 3. (if there was a surplus) against dividend income

• This is the default, however taxpayers can allocate their personal allowance between different types of income however they want

• Unused personal allowance cannot be carried forward to future years (unless marriage allowance applies)

• Where taxpayers income exceeds £100,000, the personal allowance is reduced by £1 for every £2 of income over the £100,000 limit

• Once a taxpayer’s income reaches £125,140 they will not have a personal allowance as it would have been reduced to zero

Marriage Allowance

• If a person does not earn more than the personal allowance for that tax year, they can transfer £1260 of their personal allowance to their spouse or civil partner

• This is not available if the recipient is a higher or additional rate taxpayer

Blind Person’s allowance

• Any taxpayer who is registered blind receives an allowance of £3,250, which is subtracted from net income just like the personal allowance

Property and Trading Allowances

• Allowances for small amounts of property income and trading income are, generally, available to all UK taxpayers

• If the individual is in receipt of gross property income or gross trading income below £1000 - the income will not be subject to income tax

  • Taxpayers of this category also do not have to submit a tax return, or if they have another income declare this in their tax return for that

• Where gross property or trading income is in excess of £1000, the taxpayer can choose to take the £1000 allowance as a deduction from gross income rather than deducting specific expenses

  • This is unless the expenses are more than their income - then it is more beneficial to deduct expenses rather than £1000 allowance

9.5 How to calculate income tax - Personal Savings Allowance (PSA)

• PSA can be set against savings income, so that up to £1,000 of savings income will be tax free

  • Basic rate taxpayer - their PSA is £1000

  • Higher Rate taxpayer - their PSA is £500

  • Advanced Rate Taxpayer - they have no PSA

• The amount of the PSA to which a taxpayer is entitled depends on whether the taxpayer is a
  basic or higher rate taxpayer

• Additional rate taxpayers do not receive a PSA

• 
  

9.5 How to calculate income tax - Dividend Allowance

• The dividend allowance is £500

• This means the first £500of a taxpayer’s dividend income will be free from tax

• Unlike personal allowance which is reduced or excluded for high rate tax payers - this allowance applies to all taxpayers irregardless

9.5 How to calculate income tax - Nil rate bands

• Although the PSA and dividend allowance are described as allowances, HMRC does not view
  them in the same way as the personal allowance - as they are not deducted from taxable income like personal allowance

• Basically seen as PSA and dividend allowance just being taxed at a rate of 0%

9.5 How to calculate income tax - Step 4: Calculate the tax on each type of income and Step 5: add together to give overall income tax liability

• The rates of income tax increase as the taxpayer’s income increases

• Rates are different for different types of income

• Finding Taxable NSNDI -

  • Taxable income - savings and dividend income = taxable NSNDI

Order of Taxation

• NSNDI is taxed first

• Savings Income is taxed second

• Dividend Income is taxed third

NSNDI Rates

• Basic Rate of 20% - £0-£37,700

• Higher Rate of 40% - £37,701-£125,140

• Additional Rate of 45% - Over £125,140

Savings Income

• Remember first £1000 is 0% taxed if you are a basic rate taxpayer and £500 0% taxed if you are a higher rate taxpayer - none if you are additional rate

• Starting rate of 0% for savings - £0-£5000

• Savings basic rate of 20% - £5,001–£37,700

• Savings higher rate of 40% - £37,701–£125,140

• Savings additional rate of 45% - Over £125,140

Dividend Income

• Dividend ordinary rate of 10.75% - £0– £37,700

• Dividend upper rate of 35.75% - £37,701–£125,140

• Dividend additional rate of 39.35% - Over £125,140

9.8 Taxation of sole traders

• Sole traders are almost always subject to income tax, and may also have to pay capital gains tax (‘CGT’) or inheritance tax (‘IHT’), depending on their circumstances and the nature of their trade

• If they make chargeable supplies exceeding £90,000 in any period of 12 months, sole traders will also be required to register for VAT

• Sole traders determine their trading profits with reference to an accounting period, which is usually 12 months long - they choose the period to suit them

• Better to align this with the tax year though

9.9 Taxation of Partnerships

• Because partnerships are not separate legal entities, this means the tax liabilities fall on partners individually - this is why its important to distinguish between partners profits

• Partners who are individuals may have to pay income tax on trading profits and other income, capital gains tax on capital profits, and inheritance tax

Steps for calculating the income payable by a partner in a partnership:

1. The partnership’s trading profit will be calculated in the same way as trading profit for a
   sole trader. The formula is:
   Chargeable receipts - deductible expenditure
   LESS capital allowances = trading profit/loss

2. The trading profit is shared between the partners in accordance with their agreement (if no agreement, the Partnership Act 1890)

3. Each partner will include this figure on their tax return and will be assessed for income tax in the normal way (applying any reliefs or allowances)

• If the partnership makes a trading loss instead, the losses will again be shared between the partners in accordance with their agreement, and the partners can each choose how they will claim any applicable reliefs for their share of the loss

• Change in members of partnership

  • New partners and retiring partners will be assessed to income tax differently, because for them, the business is either a new one or is coming to an end

  • When partners join or leave a partnership part way through a tax year, their tax liability will
    be calculated using the apportionment principle, ie profits and losses will be apportioned
    between the different tax years.

  • This will usually be calculated on the basis of the number of days of the accounting period falling in each tax year

9.10 Income tax relief on borrowings

• If an individual borrows money to buy a share in a partnership or to lend money to a partnership, they can deduct the interest they pay on this borrowing from total income

• This is because this is a ‘qualifying loan’

• There is a cap on the amount of tax relief, of the greater of £50,000 or 25% of the taxpayer’s total income less allowable pension contributions in the tax year where the relief is claimed

• Cap only related to income from sources other than the trade which produced the loss

9.11 Limited liability partnerships

• When an LLP is used to carry on a trade or profession, it will be treated for most purposes
  in the same way as an ordinary partnership as far as income tax is concerned

• However, the availability of relief for trading loss is restricted for partners in an LLP in certain conditions

9.12 Taxation of Shareholders

• Shareholders pay tax on dividends

Loan to a participator in a close company

• When a ‘close company’ makes a loan to a shareholder, there may be income tax
  consequences for the shareholder if the close company writes off the loan

Share buyback

• When a shareholder sells their shares back to the company in which they are held, their profit will be the difference between the sale price and the issue price of the shares

• This will likely be charged to income tax same way as a dividend

• Sometimes shareholders will pay CGT instead on profit

Income tax relief

• Tax legislation includes two income tax reliefs for shareholders

• 1. When an individual borrows money to purchase ordinary shares in a close company that carries on a trade, or to lend money to a close company that carries on a trade

• 2. Income tax relief under the Enterprise Investment Scheme (EIS) - broadly allows the individual to deduct from their income tax liability for the year a sum equal to 30% of the amount they have invested
  in the ordinary shares of qualifying unquoted companies

9.13 Interest received on loans and debentures

• Under the ITTOIA 2005, a lender must pay income tax on interest received in relation to a loan (unless the lender is a company and therefore pays corporation tax)

• If the lender/debenture-holder is a company, interest received is income, chargeable to corporation tax.

9.14 Taxation of directors and other employees

• Salaries, fees and other benefits paid to employees are deductible expenditure when calculating trading profits

• Businesses’ trading receipts will frequently be reduced to nil or almost nil once salaries have been deducted - this is the biggest expense

• Employees, including directors, pay income tax on employment income, pensions income and Social Security income

• Employment income includes ‘earnings’, which means all benefits received by the employee
  (or director) which derive from their office or employment as a reward for their services

  • Irregardless of whether paid by the employer or a third party

  • Tips, bonuses, non-cash benefits are also taxable

  • Personal Gifts are not taxable because these are not a reward for services

  • Starting lump sums, compensation for unfair or wrongful dismissal are taxable

Non-Cash Benefits

• Still taxable

• Some circumstances where no tax will be charged to the employee:

• Accommodation, employees are not charged to tax if;

  • it is necessary for the employee to live on the premises in order to perform their duties, for example, certain caretakers; or

  • the accommodation is provided so that the employee can perform their duties better and it is customary in that type of employment to have their accommodation provided, for example, a police officer.

• Interest-free or low-interest loans - if the employee benefits from special rate loans from the employer there is no charge to tax when the total amount outstanding on any loans to that employee does not exceed £10,000 at any time in the tax year.

• Employer’s pension contributions - Directors and other employees are not taxed on the employer’s pension contributions if they are paying into an HMRC approved scheme

• Share Schemes - Sometimes employers provide non-cash benefits relating to shares in the employer company. There are possible tax advantages for both parties in using the schemes

• Deductible expenditure - An employee can deduct from their income expenditure which is incurred wholly, exclusively and necessarily in the performance of their duties. This is a stricter test than that for deductible expenditure when calculating trading income.

9.15 Collection of income tax and dates for payment

• Tax can be collected in two ways - Deduction at Source and Self-Assessment

Deduction at Source

• Tax on salary, cash and most non-cash benefits is generally deducted at source by the employer

• When tax is deducted at source, the payer of the income acts as a tax collector

• They deduct the right amount of tax and pay it to HMRC

Self-Assessment

• Anyone who receives any income from which the tax has not been deducted at source must complete a tax return, declaring all their income for the tax year

• Any income tax which has been deducted at source should be included on the tax return and the taxpayer’s tax liability will be reduced by the amount of income tax that has already been paid

• The Tax Return -

• Must be sent within 6 months of the end of the tax year to HMRC

• If late, there will be a default fine

When does tax have to be paid?

• There are different tax returns for different types of income and they are issued soon after 5 April each year.

• Taxpayers are encouraged by HMRC to file an online tax return.

• The online tax return and any payment must be filed by 31 January following the tax year to which the return relates.

• If the taxpayer wishes to file a paper return, the submission date is earlier: no later than 31 October

• The taxpayer must make two payments on account towards the income tax due for any tax year, and a final balancing payment to meet any tax still outstanding. The payment dates are:

  • first payment on account: by 31 January in the tax year in question;

  • second payment on account: by 31 July after the end of the tax year; and

  • any balancing payment (calculated once the tax year is over) is due on the next 31 January

How much are payments on account?

• The first and second payments should each be approximately half of the taxpayer’s tax
  liability, based on the previous year’s accounts.

• However, the payments are reduced to give
  credit for any tax deducted at source

• The taxpayer does not have to make a payment on
  account if the amount remaining after giving credit for tax deducted at source is below a
  certain limit

  • Important because it means these people are not required to make payments on account: Most employees, pensioners, others who receive most of their income after deduction at source, or those who have relatively small tax liabilities

• Taxpayers can claim a reduced payment on account or cancellation of the payment on account if they have grounds for believing that if they make payments on account based on the previous year’s accounts, this will result in an overpayment of tax in the current tax year.

Penalties for default

• HMRC charges interest on any tax unpaid at the due date for payment.

• This applies to both payments on account and balancing payments. There are also fixed penalties – fines – for late or non-payment.

• Taxpayers must maintain adequate records to support the information in their tax return, and
  there is a penalty for default.

• HMRC has the power to carry out audits and make enquiries to check whether the tax return is accurate.

• Taxpayers can appeal against assessments to the
  First-Tier Tribunal (Tax)

9.16 Tax Avoidance

• Using tax law to reduce their tax bill in a way that is not unlawful but not ‘within the spirit of tax legislation’

Abusive tax arrangements

• The Finance Act 2013 allows HMRC to make adjustments to a taxpayer’s liability to counteract
  the tax advantages arising from abusive tax arrangements (s 209).

• The burden is on HMRC to
  show that the arrangement is abusive

• Section 207 of the Finance Act 2013 defines ‘tax arrangement’ and ‘abusive’.

  • An arrangement is a ‘tax arrangement’ if, having regard to all the circumstances, it would be reasonable to conclude that the obtaining of a tax advantage was the main purpose, or one of the main purposes, of the arrangement.
    

  • A tax arrangement is ‘abusive’ if entering into or carrying out the arrangement cannot
    reasonably be regarded as a reasonable course of action in relation to the relevant tax
    provisions, having regard to all the circumstances.

    • The circumstances include;

    • whether the effect of the arrangement is consistent with the policy objectives of the tax legislation;

    • whether the means of achieving those results involves one or more contrived or abnormal steps; and

    • whether the arrangements are intended to exploit shortcomings or loopholes in the tax legislation

  
  

• If tax arrangements align with an established practice and HMRC has accepted this previously - it seems this would not be considered abusive

Procedure

• If the HMRC find a taxpayer in breach of GAAR - they will notify the taxpayer why they think there has been benefit from an abusive arrangements

• They will then set out the tax adjustments to counteract this that will be needed

• These adjustments must be ‘just and reasonable’ - can be made by the taxpayer or HMRC

• If counteraction is proposed by HMRC, the taxpayer is permitted to make written representations in their defence.

• The matter will then be referred to the GAAR advisory panel (‘Panel’), who will issue their opinion by way of a notice to the taxpayer and HMRC

• HMRC will then, provided that they still agree with the Panel’s opinion, give the taxpayer a written notice setting out whether the tax advantage arising from the arrangements is to be counteracted under the GAAR, the adjustments required and the steps that the taxpayer must make to give effect to the adjustment.

• Under the Finance (No 2) Act 2017, anyone who enables an abusive tax arrangement may
  be required to pay a penalty.

• An enabler is any person who, in the course of their business, enables the abusive tax arrangements that are defeated.